Gulf Oil Corp.–Acquisition
Summary of facts
o George Keller of the Standard Oil Company of California (Socal) is trying to determine how much he wants to bid for Gulf Oil Corporation. Gulf will not consider offers below $70 per share even though its last closing price per share was valued at $43.
o Between 1978 and 1982, Gulf doubled its exploration and development spending to increase its oil reserves. In 1983, Gulf began to cut exploration spending sharply due to falling oil prices when Gulf management bought back 30 million of its 195 million shares outstanding.
o The acquisition of Gulf Oil was due to a recent attempted acquisition by Boone Pickens, Jr. of Mesa Petroleum Company. He and a group of investors had spent $638 million and had obtained about 9% of all outstanding shares of Gulf. Pickens engaged in a power struggle for control of the company, but Gulf executives opposed Boone’s takeover as he pursued a $65-per-share partial public offering. Gulf then decided to liquidate on its own terms and contacted several companies to participate in this sale.
o The upgrading opportunity was Keller’s main attraction to Gulf and now he has to decide whether Gulf, if liquidated, is worth $70 a share and how much he will bid for the company.
o What is the value per share of Gulf Oil if the company is liquidated?
o Who is Socal’s competition and how is it a threat?
o What should Socal offer for Gulf Oil?
o What can be done to prevent Socal from operating Gulf Oil as a going concern?
Major competitors for Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO, and of course Socal.
o Currently owns 13.2% of Gulf shares at an average purchase price of $43.
o Borrowed $300 million against Mesa securities and made an offer of $65/share for 13.5 million shares, which would increase Mesa’s holdings to 21.3%.
o Under reinstatement, they would have to borrow many times the value of Mesa’s equity to obtain the majority needed to gain a seat on the board.
o Mesa is unlikely to raise that much capital. Still, Boone Pickens and his investment group will make a substantial profit if they sell their current shares to the winner of the auction.
o The offer price is likely to be less than $75 per share, as an offer of $75 will cause your debt ratio to skyrocket, making it difficult to borrow anything else.
o Socal’s debt is only 14% (Exhibit 3) of total capital, and the banks are willing to lend enough to bid on the $90 possible.
o Specializes in leveraged buyouts. Keller feels that his is the bid to win as the heart of his bid is the preservation of Gulf’s name, assets and jobs. Gulf will essentially be a going concern until a longer-term solution can be found.
Socal’s offer will be based on the value of Gulf’s reserves without further exploration. Gulf’s other assets and liabilities will be absorbed into Socal’s balance sheet.
Gulf Oil Weighted Average Cost of Capital
o Gulf’s WACC was determined to be 13.75% using the following assumptions:
o CAPM used to calculate cost of capital using beta of 1.5, risk-free rate of 10% (1-year Treasury bill), market risk premium of 7% (Ibbotson Associates arithmetic mean data from 1926 to 1995 ). Cost of equity: 18.05%.
o The market value of capital was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used because it is the uninflated value before takeover attempts drove the price up. Equity market value: $4,959 million, weighting: 68%.
o The value of the debt was determined using the book value of the long-term debt, $2,291. Weight: 32%.
o Cost of debt: 13.5% (given)
o Tax rate: 67% calculated on the net income before taxes divided by the income tax expense.
Gulf Oil Valuation
Gulf’s value is made up of two components: the value of Gulf’s oil reserves and the value of the company as a going concern.
o A projection was made starting in 1983, estimating oil production until all reserves were exhausted (Annex 2). Production in 1983 was 290 million composite barrels, and was assumed to be constant until 1991 when the remaining 283 million barrels would be produced.
o Production costs were held constant relative to the amount of production, including depreciation due to the unit of production method currently used by Gulf (production will be the same, so the amount of depreciation will be the same)
o Because Gulf uses the LIFO method to account for inventory, new reserves are assumed to be expensed in the same year they are discovered and all other exploration costs, including geological and geophysical costs, are charged against income as it is incurred.
o Since there will be no further exploration in the future, the only expenses that will be considered are costs related to production to deplete reserves.
o The price of oil was not expected to increase in the next ten years, and since inflation affects both the selling price of oil and the cost of production, it cancels itself out and was negative in the cash flow analysis .
o Income minus expenses determined the cash flows for the years 1984-1991. Cash flows cease in 1991 after all oil and gas reserves are liquidated. Derivative cash flows account only for the liquidation of oil and gas assets, and do not account for the liquidation of other assets such as current assets or net property. The cash flows were then discounted to net present value using Gulf’s cost of capital as the discount rate. Total cash flows until liquidation is completed, discounted by Gulf’s 13.75% discount rate (WACC), amount to $9,981 million.
The value of Gulf as a going concern
o The second component of Gulf’s value is its value as a going concern.
o Relevant to the valuation because Socal does not plan to sell any Gulf assets other than its oil under the settlement plan. Instead, Socal will use other Gulf assets.
o Socal can choose to turn Gulf back into a going concern at any time during the liquidation process, all that is needed is for Gulf to begin the exploration process again.
o Going concern value was calculated by multiplying the number of shares outstanding by the 1982 share price of $30. Value: $4,959 million.
o 1982 share price chosen because it is the value that the market assigned before the price was raised by the takeover attempts.
o When two companies merge, it is common practice for the acquiring company to overpay for the acquired company.
o It makes the shareholders of the acquired company benefit from the overpayment and the shareholders of the acquiring company lose value.
o Socal’s responsibility is to its shareholders, not to the shareholders of Gulf Oil.
o Socal has determined the value of Gulf Oil, in liquidation, at $90.39 per share. Paying anything above this amount would result in a loss for the social shareholders.
o The maximum offer amount per share was determined by finding the value per share with Socal’s WACC, 16.20%. The resulting price was $85.72 per share.
1. This is the price per share that Socal must not exceed to continue to profit from the merger, because Socal’s WACC of 16.2% is closer to what Socal expects to pay its shareholders.
o The minimum offer is usually determined by the price the shares are currently selling for, which would be $43 per share.
1. However, Gulf Oil will not accept an offer of less than $70 per share.
2. In addition, the addition of the competitor’s willingness to bid at least $75 per share raises the price of the winning bid.
o Socal took the average of the high and low bid prices, resulting in a bid price of $80 per share.
Maintain the value of social networks
o If Socal buys Gulf for $80, it is based on the liquidation value of the company and not as a going concern. Therefore, if Socal operates Gulf as a going concern, its shares will be devalued by about half. Socal shareholders’ fear that management could take over Gulf and control the company as it stands, which is only valued at its current share price of $30.
o Post-acquisition, there will be large interest payments that could force management to improve performance and operational efficiency. The use of debt in acquisitions serves not only as a financing technique but also as a tool to force changes in managerial behavior.
o There are some strategies that Socal could employ to assure shareholders and other relevant parties that Socal will acquire and use Gulf at the appropriate value.
o A covenant could be executed at or before the time of the offer. It would specify Socal’s management’s future obligations and include its liquidation strategy and projected cash flows. Although management may respect the agreement, there is no real motivation to prevent them from implementing their own agenda.
o Management could be supervised by an executive; however, this is often an expensive and inefficient process.
o Another way to reassure shareholders, especially when monitoring is too costly or too difficult, is to make management’s interests more like those of shareholders. For example, an increasingly common solution to the difficulties arising from the unbundling of ownership and management of public companies is to pay managers in part with company shares and stock options. This gives managers a powerful incentive to act in the interests of owners by maximizing shareholder value. This is not a perfect solution because some managers with many stock options have committed accounting fraud to increase the value of those options long enough to cash in some of them, but to the detriment of their company and its other shareholders. .
o It would probably be most beneficial and least costly for Socal to align its concerned managers with shareholders by paying their managers in part with shares and stock options. There are risks associated with this strategy, but it will definitely be an incentive for management to liquidate Gulf Oil.
o Socal will make an offer for Gulf Oil because its cash flows reveal that it is worth $90.39 in liquidated condition.
o Socal will bid $80 per share, but limits additional bids to a cap of $85.72 because paying a higher price would hurt Socal shareholders.